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Crude Realities: Price Volatility is Here to Stay

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North American crude-oil markets have endured some wild fluctuations in recent years, reflecting the disconnection between surging domestic hydrocarbon production and associated midstream (pipelines) and downstream (refineries) capacity to handle these volumes.

In late 2010, the historical price differential between West Texas Intermediate (WTI) and Brent crude oil started to widen dramatically because of local logistical constrains and an uptick in volumes arriving at the hub in Cushing, Okla., the delivery point for WTI.

Source: Bloomberg, Energy & Income Advisor

An influx of crude oil from the Bakken Shale and western Canada, coupled with insufficient southbound takeaway capacity from Cushing to the Gulf Coast’s refinery complex, resulted in a growing supply glut that depressed the price of WTI relative to Brent and other benchmarks that reflect global supply and demand conditions.

This disparity peaked on Oct. 19, 2011, when a barrel of WTI crude oil traded at a $28.08 discount relative to Brent.

However, as we explained in Getting Back Together, the spread between these two oil benchmarks narrowed over the summer, reflecting the start-up of several pipeline projects.

Enbridge (TSX: ENB, NYSE: ENB) and Enterprise Products Partners LP (NYSE: EPD) in early 2013 completed the reversal and initial expansion of their Seaway pipeline, which can transport up to 400,000 barrels per day from Cushing to the Gulf Coast.

At one point in mid-July, WTI crude oil even traded at a premium of $0.08 per barrel to Brent.

But the convergence of these two crude-oil benchmarks proved fleeting; WTI now trades at a discount of $13.09 per barrel as of Oct. 30, 2013.

For the first time, this weakness has extended to Light Louisiana Sweet (LLS) crude oil, a coastal benchmark that traditionally has tracked the price of Brent crude oil because it competes with seaborne imports from international markets.

Source: Bloomberg, Energy & Income Advisor

The recent weakness in the price of LLS crude oil suggests that the influx of crude oil to the Gulf Coast from new pipeline capacity, rail deliveries and surging production from the Eagle Ford Shale in south Texas has pushed this regional market into an oversupply.

Light Louisiana Sweet crude oil now trades at a discount of $10.89 per barrel to Brent, and its premium relative to WTI has shrunk to $2.20 per barrel–less than the cost of transportation from Cushing to Saint James, La., the delivery point for LLS.

Rising inventories of crude oil in Petroleum Administration for Defense (PADD) 3–Alabama, Arkansas, Louisiana, Mississippi, New Mexico and Texas–suggests that the oversupply of light-sweet crude oil that had been bottlenecked in Cushing has migrated to Houston and Saint James.

Source: Bloomberg, Energy & Income Advisor

Some of this weakness in LLS prices reflects seasonal refinery turnarounds on Gulf Coast, which reduces crude-oil consumption in the region. However, this development gives credence to Plains All American Pipeline LP’s (NYSE: PAA) forecast that the US eventually could face an oversupply of light-sweet crude oil.

Which companies stand to profit from growing US production of light-sweet crude oil and their movement to the US Gulf Coast?

Gulf Coast refiners such as Valero Energy Corp (NYSE: VLO) are geographically well-positioned to take advantage of this trend, but must invest in facility upgrades after gearing up to process increasing volumes of heavy crude oil.

Master limited partnerships that own strategically located terminal and storage facilities in the Gulf Coast also stand to benefit from an upsurge in demand and higher rates on renewing contracts.

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